IF CHANGES IN prices are supposed to be triggered by changes in supply-and-demand fundamentals, then the rise of oil in March past $110 a barrel, on a day when data showed rising inventories and slowing demand growth and it’s subsequent fall days later blamed on a strengthening US dollar, seem to suggest that other factors are at work.
Indeed, those looking to understand oil’s more than 40% rise since last year will also be hard pressed to find their answer in short-term supply-and-demand fundamentals in the market for the physical product, which have not moved anywhere near as much.
Oil’s present disconnect from fundamentals has arisen not so much from the billions of investment dollars pouring into commodities in general as from its paper product’s transformation into the hedge du jour against rising inflation and the falling dollar.
Although Standard & Poor’s estimates that investors have poured as much as $40 billion into commodity investments since the start of the year, it is hard to pin the blame on new investor dollars for the rising use of oil as an inflation and dollar hedge. A recent survey of commodity investors by Barclays Capital suggests that only 11% are most attracted to the asset class for its potential as a hedge against inflation. Diversification, cited by 53% of respondents, and absolute performance, cited by 30%, are investors’ main reasons for investing in commodities. With most of the new inflows coming from pension funds and other institutions interested in increasing their allocation to commodities for its long-term benefits, the exploitation of oil as a hedge appears to be coming from more fast-moving and speculative players rather than the new money coming into the market from investors.
Although the use of oil as a hedge against inflation makes sound sense, as the price of oil has been the main driver of inflation for the past five years, oil’s emergence as a principal hedging instrument against the falling dollar is more recent and, some worry, less well founded.
"Gold is the classic dollar hedge with a long historical relationship," says Frédéric Lasserre, head of commodities research at Société Générale. "What’s amazing today is that oil and even some base metals are now showing an even stronger correlation with the dollar. This has encouraged oil’s use as a hedge against the dollar but I am not convinced that commodities other than gold should be used for this purpose because the mechanism is not clear. The mechanism implied by the oil-to-dollar ratio is that the higher the price of oil, the more oil producers accumulate dollar reserves and the more dollars they sell because they want to maintain their currency pegs and diversify into euros. That’s where the correlation comes from but what that shows is oil’s influence on the dollar rather than the dollar’s influence on oil. I don’t believe the argument that the falling dollar supports commodity prices because producers raise prices to compensate for the weaker dollar, because that implies that producers are able to raise prices. Even Opec, one of the most powerful cartels, doesn’t have that kind of pricing power any more. Changes in production quotas have a much lesser impact on prices than they used to."
Blaming investors
It is difficult to imagine how the huge inflow of investor cash into commodities could not have an impact but it is important to understand what that impact is and what it is not.
Given that the total amount of investments in commodity indices and other structured and exchange traded funds is estimated at between $150 billion and $270 billion, the $40 billion increase since the start of the year means an immediate jump of 15% to 25% in new investments, a size difficult for any market to digest.
JPMorgan estimates that hedge fund participation could amount to another $200 billion. Calpers (the California Public Employees Retirement System) alone announced that it would increase its investments in commodities from $450 million as of the end of 2007 to more than $7 billion by 2010. Interestingly, part of the increase in investments has come from sovereign wealth funds of commodity-producing countries, including, it is believed, the sovereign wealth fund of a Middle Eastern Opec country, raising the spectre that a government earning money from physical oil is also investing in paper oil with the expectation that underlying prices might rise.
It is clear that in some cases investor demand has had a significant impact on prices as, for example, gold and silver exchange traded funds are backed by physical holdings of the metal, creating another source of demand for the commodity. Street Tracks Gold Trust, the largest gold ETF, holds 655 tonnes, making it the eighth-largest holder of gold in the world.
In the oil market, converting the amount of interest held by investors into physical barrels represents a demand increase equivalent to that coming from real demand in China.
But attributing too much to investor influence is simplistic and quite often plain wrong. In 2006, when oil futures were in contango, many blamed the high amount of passive long interest at the short end of the curve for the phenomenon. Despite the fact that investors continued to pour money into commodities in 2007, however, oil moved back in to backwardation as inventories rose, making it clear that low inventories in the previous year, rather than investor cash, were the real cause for the shape of oil’s forward curve.
Although speculative money has helped increase intra-day volatility in many commodity markets, long-term trends remain driven by fundamentals.
"There is no real reason to look beyond fundamentals to explain price actions in commodities," says the head of commodities research at an investment bank with a leading commodities franchise. "If you look at the total open interest in a commodity like oil, for example, about 50% comes from producers and 35% from physical consumers. About 10% of the remaining open interest comes from passive index investors and the remaining 5% from hedge funds and CTAs. The critical point here is that producers, consumers and index investors do not go in and out of these markets. An index investor buys oil and stays in it for five years. Hedge funds and CTAs have a big impact on daily volatility but not on long-term price trends. Commodity markets are physical markets, and what separates them from financial markets is that they are markets for spot assets as opposed to anticipatory assets like equities or bonds. The prices for spot assets are driven by spot conditions whereas the prices for anticipatory assets are driven mostly by expectations."